UBS’ $10 million capped buffer Gears on Nasdaq-100 well-positioned to reward bearish bets

By Emma Trincal

New York, May 19 – For investors bearish on tech stocks and equity markets in general, UBS AG, London Branch’s $10 million of 0% bearish capped buffer Gears due Jan. 31, 2024 linked inversely to the Nasdaq-100 index offer good return prospects, a contrarian portfolio manager said. In an “overvalued” market dominated by speculation, bears via the note may capitalize on a sharp market drop.

If the index declines, investors will gain 3% for every 1% decline of the index, subject to a maximum return of par plus 27.6%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes flat or gains by no more than 8%, the payout will be par.

Otherwise, investors will lose 1% for each 1% gain of the index above the 108% threshold level, with losses capped at 92%.

Index divergences

“Eight and a half months is a reasonable time period. I like it,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

Kaplan is bearish on U.S. equities, particularly on the tech heavy Nasdaq-100 index. The index allocates nearly 60% to the technology sector.

He explained why he anticipates further market declines.

“There is an important divergence between the indices in 2023,” he said.

The Nasdaq-100 index surged this year, but the S&P is “lagging,” and the Russell has “done poorly,” he noted.

“This divergence is similar to what we had in 2021 before the big drop,” he said.

“It definitely is a red flag.”

The Nasdaq-100 index entered bear market territory on Nov. 19, 2021 scoring a peak at that point.

The S&P 500 index followed suit after clocking its record high on Jan. 4, 2022. If the S&P 500 has rebounded this year, it still remains 13% off its peak of January 2022.

The Russell 2000 is the laggard trading nearly 28% below its Nov. 8, 2021 high.

The Nasdaq has enjoyed a spectacular rally this year, soaring 26%, but has yet to recover its losses, he said.

The Nasdaq-100 index closed 20.4% off its November 2021 high when the notes priced last week at 13,347.83.

“All of the indices have made lower highs from their peaks. They haven’t recovered. This is typical of bear markets,” he said.

“I expect to see a few more lower highs in the short term. But we’re getting close to the highest point.”

Dollar, inverted curve

Performance divergences between the indexes make for a “pretty reliable signal” of further declines, he said.

Another “very reliable signal” is the recent appreciation of the U.S. dollar.

“People who buy the dollar are experienced investors who anticipate dramatic price declines in the stock market. I would say the dollar moving up is the most important signal of an upcoming downtrend,” he said.

Finally, the inverted Treasury curve constitutes another warning sign, he said.

“Yields are much, much higher on the low end. And it’s true across the curve. Historically, an inverted yield curve has been reliable 99.3% of the time,” he said.

The yield on the three-month Treasury bill for instance is 5.284% versus 5.03% for the one-year. The three-year Treasury yields 3.958% and the 10-year, 3.678%.

Crowded trade

“The Nasdaq is particularly vulnerable to a downturn because it is more overpriced, more concentrated, and heavily weighted on big tech names,” he noted.

He noted for example that Apple’s market capitalization is greater than the entire Russell 2000 index.

“The top names in the index, Apple, Microsoft, Amazon, Nvdia, are all trading triple their fair value, way above where they should be.

“The more overpriced the stocks, the more people continue to buy them,” he said.

Kaplan said he pays special attention to the VIX, which measures the expected volatility of S&P 500 index options over the next 30 days.

At the beginning of May, the volatility index hit its lowest point since November 2021.

“The VIX is very depressed, but it has begun to make higher lows, which is another sign that stock prices are about to fall,” Kaplan said.

Even market sentiment can help predict market shifts, he noted.

“Fear of missing out is everywhere. The extended rebound has made more and more people believe that last year’s bear market is over,” he said.

The Nasdaq’s spectacular rally since the beginning of the year is just another red flag, according to Kaplan.

“Investors are chasing the same tech names. Everybody believes that the market will continue to go up indefinitely. This is one of the most dangerous phases of a bear market,” he said.

The wrong signal

Hopes of a possible ending of the Fed’s tightening cycle are creating misplaced expectations, he added.

“A lot of people are bullish right now because they expect a rate cut. They see it as the trigger for a new bull run. But history shows us the opposite. Historically, when the Fed starts cutting rates, the stock market collapses or deteriorates drastically,” he said.

In the fall of 2008, for instance, stock prices plummeted in reaction to the Fed cutting rates, he noted.

“It was the most severe period of the 2007-2009 bear market.

“The market didn’t respond well to the rate cuts. Rate cuts meant that something bad was going on,” he said.

The same pattern also took place during the 2000-02 bear market and in 1974, he said.

All these signals point to dramatically lower U.S. stock prices over the remaining part of the year, he said.

Bearish spectrum

“We may have a few more rebounds, but overall, the market is going to experience severe losses in 2023,” he said.

The eight-month timing of the notes worked well in that regard.

“I think you can easily get the full cap amount during that timeframe especially when you have so much leverage.”

On an annualized basis, the maximum return for noteholders is close to 40%.

“You might be able to make more money being short the index. But if the Nasdaq doesn’t go down much, at least you have the leverage, which is a good thing.

“I see all the signals converging in the same direction. The market is due for a big drop. So personally, I would rather have a higher return potential and less leverage.”

The 8% buffer should appeal to most investors lacking full confidence in their own bearish bet.

“Some people may want that protection. Personally, I think there is very little chance that the Nasdaq would be up more than 8% in January 2024. In fact, I think it’s unlikely that it would be up at all.

“But again, it depends on your view. Overall, I think it’s a good note. You have a pretty good chance to get your cap. And the cap is pretty attractive,” he said.

The notes are guaranteed by Goldman Sachs Group, Inc.

UBS Securities LLC and UBS Investment Bank are the agents.

The notes settled on May 15.

The Cusip number is 90289X431.

The fee is 1%.

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